Inflation and Monetary Policy

Recently, I posted an expanded version of my Fresh Take interview. In that piece, I focused on various facets of inflation, but did not address the role of monetary forces. On November 23rd, two prominent economists – Paul Krugman and Raghuram Rajan – provided contrasting views of how the Federal Reserve Bank (FED) should respond to inflation as recently experienced in the United States. In this post, I will attempt to summarize each of their views and then indicate which I find more convincing and why.

In his November 23rd op-piece in the New York Times entitled “How Softies Seized the Fed,” 2008 Nobel Prize winner Paul Krugman comments include the following points:

  • Both Jerome Powell (the re-nominated chair of the FED) and Lael Brainard (nominated as vice-chair and considered as a potential chair of the FED) can be viewed as monetary doves; that is, they give more weight to the effects of interest rates on employment and GDP than they do to present and potential inflation.
  • The period of 1970-1995 in the U.S. featured a negative relationship between the unemployment rate and changes in the core inflation rate – consistent with the Natural Rate Hypothesis espoused by Edmund Phelps and Milton Friedman.
  • For the period from 1995 through 2019, this negative correlation disappeared; that is, changes in the unemployment rate bore no consistent relationship with changes in the inflation rate. “Notably, unemployment dipped below 4 percent at the of the 1990s and at the end of the 2010s, in each case without provoking accelerating inflation.”  Furthermore, over the past decade, we have experienced close to the zero lower bound for interest rates on Treasuries without generating inflation.
  • Based on these observations, he concludes: “The past couple of decades have highlighted the downsides of hawkishness, and the FED doesn’t want to repeat what it now, quietly, views as past mistakes.” Krugman characterizes such mistakes crisply: “If it raises interest rates and that pushes the economy into a recession, it might not be able to cut rates enough to get us out again.”

On the same date, Raghuram Rajan – former chief economist for the International Monetary fund and Governor of the Reserve Bank of India – had an opinion piece entitled “Monetary and Inflationary Traps” published on the Opinion page of Project Syndicate, an online periodical that reflects the views of many influential people in various aspects of global affairs. Rajan’s comments include the following:

  • Contemporary central bankers (CBs) “are reticent to see inflation as a problem.”
  • In the past, CBs treated inflation as their primary concern. In contrast, in the U.S., the FED has changed its inflation targeting objective from 2% to an average of 2% over an unspecified period in order to guard against premature tightening of monetary policy that could stagnate the economy or even throw it into a recession.
  • He notes that “Congress has just spent trillions of dollars generating the best economy money can buy.”  Effects include booming asset markets (stock market and real estate) and sizeable private sector borrowing.
  • Rajan worries that if the FED were to declare inflation as its public enemy #1, it would not be taken as credible. Alternatively, if the FED waits too long to counter inflationary trends, it will face a problem similar to what FED Chair Paul Volcker faced in the early 1980s:  it would take very high interest rates and a major recession to bring inflation back down to its 2% target.  Such actions might raise political pressure to reduce whatever independence the FED has.
  • He also worries that central banks have already lost some of their independence from political forces that have enabled them to reliably combat inflation. For example, the FED has increased its holdings of U.S. Treasuries from $800 billion in 2008 to almost $5.6 trillion at present. This expansion enabled the Federal Government to spend without having to borrow directly from the public and, thus, expand the amount of funding available in the economy.
  • In addition, he notes that if the FED raises rates prior to other central banks, there would be upward pressure on the dollar. This would make exports less attractive and imports more attractive. Of course, this would release some of the inflationary pressures.

I find Rajan’s view more compelling. The extensive period (over a decade) of low interest rates has done more to fuel asset prices than to generate employment. Furthermore, low rates and rising asset prices have encouraged businesses to spend on equipment and new technology. These forces have both skewed hiring mostly those people with appropriate skills and increased income inequality.  I conclude with a reference to a portion of the abstract from Ed Foster’s (my former graduate school mentor and teacher) important article Who Loses From Inflation?

The most serious costs of persistent inflation may be that it destroys our confidence that society can solve its problems and creates fear that our social contract is falling apart. Coupled with the fear is resentment, based on suspicion by many that inflation treats them unfairly. Those who lose are all of us who share those fears and frustrations.


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